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Right Time to Muddy the Waters Over Lien Stripping, Again

by Starfield & Smith

The Legal Intelligencer
August 8, 2013

Recent news articles have proclaimed that housing prices are beginning to rebound. Even hard-hit locations like Las Vegas are reporting rising home values compared with last year. Despite this very welcome turnaround, many homeowners are not out of the financial woods yet. Salary reductions, periods of unemployment and loss of bonuses and other benefits still are applying pressure on many homeowners’ cash positions and their ability to keep current on living expenses.

With home values rising, but homeowners still struggling, the next big battleground in bankruptcy may be over which party will benefit from the appreciation of real property collateral. In particular, the battle likely will manifest itself in the context of so-called “lien stripping” in Chapter 7 cases.

In the real property context, lien stripping is the reduction of the amount secured by a mortgage to the value of the mortgaged property at the time the debtor files its bankruptcy petition. Debtors have much greater latitude in Chapter 13 reorganizations to strip down or strip off a lien through the plan process. The conventional wisdom supporting this view is that reorganizing debtors cede more to secured creditors in general than debtors in a Chapter 7 liquidation. The availability of lien stripping in Chapter 13 helps balance out the relative leverage of the debtor and secured creditor in reorganizations.

The legal basis for lien stripping in Chapter 7 cases comes from the interplay between Sections 506(a) and 506(d) of the Bankruptcy Code. Section 506(a) states that an “allowed claim” is “secured” only to the value of the collateral. Section 506(d) states that a lien securing a claim is void to the extent the claim is not “allowed.” When read together, the provisions can appear to work in conjunction such that Section 506(a) defines an “allowed secured claim” as “allowed” only to the extent of the value of the collateral and that Section 506(d) voids a lien against collateral to the extent the claim is not “allowed.”

In Dewsnup v. Timm, 502 U.S. 410 (1992), the U.S. Supreme Court recognized the logical appeal of reading these two provisions together. In fact, the court confided that, if the court was writing on a “clean slate,” it might have interpreted these provisions similarly. The court, however, was persuaded by the argument supported by the United States, as amicus curiae, that Section 506(a) is not intended to serve as a definitional section for use in Section 506(d). Rather, the court held that Section 506(d) serves the purpose of voiding a lien against a debtor’s property when the underlying claim is not allowed. In other words, the court held that the function of Section 506(d) is to cut off a secured creditor’s right to foreclose on collateral if the underlying claim is invalid for some reason.

The court was persuaded by the fact that this interpretation comports with pre-code bankruptcy law and the general bankruptcy principle that liens survive bankruptcy. The court noted that this interpretation did not hold up flawlessly against hypotheticals explored at oral argument. As a result, the court essentially limited its own ruling to the particular facts at issue. The court specifically stated it would “allow other facts to await their legal resolution on another day.”

That day may soon be upon the court, as two relatively recent circuit-level decisions have come down on opposite sides of the Dewsnup opinion. In McNeal v. GMAC Mortgage, No.11-11352 (11th Cir. May 11, 2012), the U.S. Court of Appeals for the Eleventh Circuit very narrowly limited Dewsnup to its facts. The Dewsnup case involved a first lien where the underlying debt exceeded the value of the collateral. Using the reasoning above, the Dewsnup court refused to “strip down” the value of the secured claim to the value of the collateral. Instead, the Dewsnup court held that the lien remained on the property for the full amount of the debt, even though the mortgage was partially underwater.

The McNeal court distinguished the facts of its case from those presented in Dewsnup. In McNeal, the Eleventh Circuit was confronted with a situation where the debtor was seeking to “strip off” a junior lien that was completely out of the money. The Eleventh Circuit reasoned that, since Dewsnup is limited to instances of “stripping down” partially undersecured liens, it was free to rely on pre-Dewsnup precedent to address the treatment of a junior lien that was completely underwater.

The Eleventh Circuit interpreted Section 506(d) as voiding a lien either where the underlying claim is disallowed or where the claim is completely unsecured under Section 506(a). The Eleventh Circuit, however, elected not to publish the McNeal opinion, so it is not controlling precedent within that circuit.

One other circuit-level decision already has followed the reasoning in Dewsnup under facts similar to McNeal. In Palomar v. First American Bank, No. 12-3492 (7th Cir. July 11, 2013), the Seventh Circuit considered the debtors’ attempt to “strip off” a second lien on their residence that was completely underwater. Unlike the Eleventh Circuit, the Seventh Circuit drew no distinction between the Dewsnup prohibition on “stripping down” a partially undersecured lien and the debtors’ present attempt to “strip off” a completely undersecured lien. In short, the Seventh Circuit viewed the issue as the debtors attempting to “strip down” the lien to zero. As such, the Seventh Circuit followed Dewsnup and prohibited the debtors from stripping off the junior lien in their Chapter 7 case.

As a result of the gradually recovering economic climate and the current state of the law, a window has opened where debtors can attempt to “strip off” underwater junior liens in Chapter 7. But that window will not stay open forever. As housing values (hopefully) continue to rise, a junior lienholder that is out of the money today may be back in the money six months from now. Once the junior lienholder becomes partially secured again, courts will be compelled to follow the Dewsnup precedent. Similarly, this conflict among the circuits over the treatment of underwater junior liens also will not continue forever. At some point, the Supreme Court again will be asked to provide definitive guidance.

Until that time, there will be many opportunities for this issue to confront underwater junior lienholders. Regardless of which side you may argue, it is time to dust off that copy of Dewsnup hiding in your research file. You may be arguing its nuances very soon and, perhaps, very regularly.